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IN THE INVESTMENT world, there’s no shortage of data. But how useful is all that data? To help get to an answer, let’s consider four questions:
1. When the economy is strong, is that good for stocks? The simple answer is “yes.” According to textbook finance, the value of any company should represent the sum total of its future profits. When the economy is strong and profits are higher, that should be good for stocks. Over time, in fact, the trajectory of the stock market has generally followed the trajectory of corporate profits.
But sometimes a strong economy can drive share prices lower. This happened just a few years ago. The economy was recovering from 2020’s pandemic, employment was improving and corporate profits were rising. But that strength contributed to higher wages and, together with other factors, the result was rising inflation. As a result, the Federal Reserve had to step in, raising rates to put the brakes on inflation.
The Fed succeeded in bringing down inflation, but those rate hikes—seven increases in one year—also caused the stock market to drop. In 2022, stocks fell 18%. This, in short, is the nature of economic cycles. A strong economy and a strong stock market tend to go together—but, at a certain point, too much positive economic data can actually be bad for stocks.
The bottom line: Be cautious in drawing conclusions about where the stock market might be headed based on current economic conditions.
2. If the stock market’s price-to-earnings (P/E) ratio is high, does that mean share prices are too high? Again, the simple answer is “yes.” While imperfect, the market’s price-to-earnings ratio can be a rough indicator of future market returns. In early 2000, for example, just before the market began to slide, the S&P 500’s P/E ratio stood at nearly 30. To put that in perspective, the market’s long-term average P/E has been about 17. In that case, an elevated P/E was indeed an accurate indicator. The market was too high and ultimately fell nearly 50%.
But if we had revisited the P/E ratio in the midst of that downturn, it would have sent a confusing signal. At the end of 2001, by which time the market had already dropped 25%, the P/E had actually risen to 46. Why, after a big market decline, would the P/E have risen? It seems like simple math that if prices had dropped, the market’s P/E should also have dropped.
The answer lies on the other side of the ratio. When the economy goes into recession, as it did in 2001, Wall Street analysts’ earnings estimates drop as well. If those estimates drop more than share prices, that can cause the market’s P/E ratio based on forecasted corporate profits to rise during a market downturn. We saw the same thing in 2009. The key point: While P/E values have a bit of predictive power, they can be misleading.
3. If the federal government is running enormous deficits, does that mean tax increases are a foregone conclusion? The federal budget deficit today is closing in on 100% of GDP, a level we haven’t seen since the 1940s. Even if Congress had the political will, cutting spending wouldn’t be easy. Social Security and Medicare account for 47% of the budget. Defense is another 14% and, because of the accumulated debt from prior years’ deficits, interest on the debt accounts for another 13% of spending.
That doesn’t leave a lot of room to maneuver and, as a result, many worry that taxes will need to rise, even above the increases already scheduled for 2026. It’s not an unreasonable fear—but things don’t necessarily have to go that way.
In the late 1980s, as we fought the last years of the Cold War, budget deficits rose to worrying levels. But that didn’t result in tax increases. Why? As the tech boom of the 1990s got going, government revenue swelled, and the debt load began to fall. At one point in the mid-1990s, the government actually ran a budget surplus. To be sure, current trends aren’t reassuring, but trends can reverse.
4. If international stocks have lower P/E ratios than U.S. stocks, does that make them more attractive? On the surface, this sounds compelling. The U.S. stock market’s P/E today is just above 20, while in developed markets outside the U.S. the average P/E is just 14. To many, this means international stocks are a bargain. But that’s not the only explanation.
As we saw earlier, a lower P/E doesn’t guarantee higher investment returns. But that’s not the only reason P/E ratios can be misleading. Another reason is that stock markets differ from country to country.
That’s important because there’s an underlying connection between a company’s growth rate and its P/E ratio. Consider two companies: Microsoft and food manufacturer General Mills. Microsoft’s P/E today is 33, while General Mills’s is around 16. But that doesn’t mean General Mills is cheap, and Microsoft is expensive. Rather, it reflects the difference between a company growing at 15% to 20% per year (Microsoft) and one that’s just barely growing (General Mills). In short, P/E ratios tend to reflect the growth rate of the business.
That helps explain why the average P/E in the U.S. is so much higher than in most of the rest of the world. International markets have far fewer fast-growing technology companies. In the U.S., seven of the top 10 companies are in technology. But in Europe, just two of the top 10 are tech companies. The same is true in most of the rest of the world. In Europe, the biggest companies are mostly slow-growing banks, food and energy companies. That explains why international markets generally have lower P/E multiples than in the U.S. Through this lens, in other words, international markets aren’t necessarily a bargain; they’re just appropriately priced for what they are.
Last week, the investment world lost a giant: James Simons, the founder of Renaissance Technologies. According to Gregory Zuckerman’s The Man Who Solved the Market, Renaissance’s flagship Medallion Fund delivered average returns of 66% per year over a 31-year period—by far, the best investment returns achieved by any investor ever.
How did Simons do it? Renaissance was the first to sift through market data, looking for hidden patterns and correlations. But despite its astonishing returns, according to an employee quoted in Zuckerman’s book, Renaissance’s system was still only right 50.75% of the time. I think there’s an important lesson in this: If even the most successful data analysts in the world are still only right 50.75% of the time, it illustrates just how hard it is to draw conclusions from market data. That’s why the best approach, in my view, is to structure a reasonable portfolio and to stick with it, despite what the data say—or appear to be saying.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and on Threads, and check out his earlier articles.
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Because Social Security should be treated as a self-supporting revolving fund, why is it considered part of the gov’t budget?
“Social Security and Medicare account for 47% of the budget.”
Another reason to have a diversified simple portfolio of ultra low cost index funds and stick with it. As the Wall Street saying goes, “Nobody knows anything”.
A lot of good information. I would have to disagree through, that raising wages are a cause of inflation. Over my working lifetime I had several jobs, the highest paying were union, and we always bargained for higher wages to make up for inflation after it started, not before. When the economist Milton Friedman was around he made a video where he said “Watch me stop inflation” and he turned off one of the government presses printing money.
On the P/E ratio, I’ve read several books, one was by Peter Lynch (One Up on Wall Street) where its said that another way to look at the P/E as the time would take to earn your invested money back in years (a P/E of 6 would be 6 years, 15, 15 years…) With many P/E’s today above single digits (some much, much higher) what are your thoughts on that?
Adam, I always find your articles informative and intellectually stimulating.
However, concepts such as the P/E ratio play no role in my investment decisions because I long ago decided to follow the advice of Bogle, Clements, Bernstein and others to stick with broad-based index funds such as VTWAX. I can’t help but wonder if, on average, those who factor P/E ratios into their equity investment decisions fare worse than those of us simply invest in broad index funds.
Much has been written about how rising or declining interest rates affect the stock market. But less is written about historical average rates, and that the rate hikes by the Fed increased rates from near zero toward a more historically average rate range. As a retiree I welcome a period of more “normal” interest rates, and am optimistic that this will not jeopardize the long term growth potential of my equities. Thanks for providing an easy to understand summary of a complex topic Adam!
I find keeping track of P/E, P/B, dividend yield, and monthly closing price for our portfolio funds gives me a sense of what to do with a bigger chunk of new cash. Is it good to invest all at once? Or, is it better to buy a chunk then start a value averaging or dollar-cost averaging path?
Great framework for pondering broader market trends. Thanks, Adam.
Great article!
Adam, you write on a variety of topics, but there is a common theme, beyond the obvious financial one. Many of your articles ask the reader to pause and think, to resist the tendency to draw conclusions from a first quick analysis of information. That’s a good, mature habit to practice for life in general.
This is a good, clear summary of how to interpret P/E ratios for a simple investor like me. Thanks for the succinct review.